Is a consumption-led recovery the “wrong” kind of growth? Photo by Oli Scarff, Getty Images.
One year ago, many were convinced the UK economy was headed for a prolonged malaise. The Bank of England had finished quantitative easing, and GDP had fallen in 6 of the previous 16 quarters. Forecasts for 2013 were dim at best. Yet here we are, with the preliminary estimate of Q4 UK GDP showing the economy grew +0.7% q/q in Q4, bringing full-year growth to +1.9%—the strongest since 2007 and the first time the UK has grown four straight quarters since Q3 2010. It’s good news any way you slice it, but some didn’t cheer—many fear the recovery “isn’t sustainable,” or it’s the “wrong kind” of growth. In our view though, reality is brighter. The UK’s economic foundation is plenty strong, and while some areas might be lagging, the groundwork is in place for them to pick up.
Most of the ongoing jitters stem from the fact household spending has been the primary driver of growth, with trade and business investment lagging. The latest GDP report doesn’t give further insight here—the first estimate shows growth only by category of output (services, production, agriculture and construction). Expenditure data come in the second estimate. For now, we simply know the biggest sector of the economy—services—is chugging right along.
Services grew +0.8% q/q, boosted by business services and finance (+1.2% q/q) and distribution, hotels and restaurants (+1.1% q/q). The sector contributed +0.61 ppt of total Q4 growth and is now 1.3% above its previous peak in Q1 2008. Production also grew (+0.7% q/q), but as it’s only 15% of the total economy, it contributed only +0.1 ppt. Construction was the one laggard, falling -0.3% q/q. However, that’s coming off two previous quarters of +2.6% growth, making it difficult to claim material weakness—especially since it was still up 1.8% y/y. Not that it much matters, considering construction comprises of only 6% of the economy and detracted only -0.02 ppts from Q4’s print.
Though we won’t know the expenditure breakdown for another month, economists believe consumers remained in the driver’s seat—hence the ongoing handwringing over potentially lackluster business investment and exports. Some say unless the UK economy shifts to an investment- and export-led economy, it won’t stay among the world’s leaders. Thing is, there is nothing magical about an export-led or investment-led model—and nothing terrible about consumption-led growth. If what they say were true, China wouldn’t be trying to re-engineer its own economy from exports and investment to consumption and services. Fact is, most developing nations want what the UK (and US) has. The notion the UK can’t keep growing using its own internationally coveted service-based model is simply misplaced.
As far as the near-term outlook, recent releases suggest growth should continue. The Leading Economic Index has risen five consecutive months, and Markit’s PMIs showed continued growth in services, manufacturing and construction in January (both in current output and new orders).
Yes, business investment remained a sore spot last year. It rose +3.1% y/y in Q1, but fell -2.3% in Q2 before rebounding with +2% growth in Q3. But this isn’t because UK businesses are inherently weak or skittish about future growth prospects—they simply can’t get financing. While mortgage lending improved markedly last year, business lending kept falling—particularly to small and midsized firms (which represent 35% of total business lending).
Businesses wanted to borrow, but banks wouldn’t lend. While lending became more profitable last year thanks to the end of quantitative easing in the UK, which allowed the spread between short-term rates (banks’ costs) and long-term rates (banks’ revenues) to widen, regulatory concerns kept them from being able to take advantage. The BoE forced banks to adopt international Tier 1 capital standards by the end of 2013—six years ahead of the world’s deadline. The big high street banks, which control the lion’s share of lending markets, had to raise capital and reduce risk on their balance sheets. Lending aggressively to small firms—widely considered riskier endeavors than big corporations—simply didn’t fit.
However, these regulatory issues are starting to clear. Banks are now largely compliant with the tougher standards, giving them more flexibility moving forward—per BoE Governor Mark Carney, they can free up as much as £90 billion, collectively. This should make it much easier for banks to lend to a wider swath of businesses, finally giving them the capital they need to invest. As this happens (and it won’t be overnight), it wouldn’t surprise us to see quite a bit of pent-up demand unleashed as businesses begin spending on research, new equipment, software and even people.
Few people appreciate this, however—the unintended consequences of regulatory wrangling aren’t exactly front-page fodder. But that’s good for stocks! It helps keep expectations relatively low, giving reality more room to surprise to the upside—a powerful force for stocks.